Over the years as we have searched for investment opportunities, we have noted a few key attributes that each successful investment has displayed. We identified these attributes by searching for a pattern between companies that have created wealth for shareholders over the years.
These attributes are as follows:
The companies product/service has a large addressable market
The company has shown consistent revenue growth historically
The company earns a high return on invested capital over an entire business cycle
The company possesses monopolistic dynamics and has sustainable competitive advantages
To gain confidence in the attributes listed above we sought out literature that confirmed our thesis about these attributes being predictors of success. Based on what we've read so far, it appears a lot of people we respect with far greater experience than ours concur that the above attributes are pivotal to a company's success.
Our first few blog posts will be dedicated to covering each of the above attributes in detail. This post as evident from the title is dedicated to analyzing the fourth point above - monopolistic dynamics and sustainable competitive advantages. Businesses with sustainable competitive advantages tend to make out sized profits relative to peers and therefore by extension deliver outsized returns to shareholders.
For the more initiated reader/investor who has heard Warren Buffet speak about his investment process over the years, a recurring theme that emerges is the concept of moats.
“ The most important thing is trying to find a business with a wide and long lasting moat around it… protecting a terrific economic castle with an honest lord in charge of the castle”
"What we're trying to find is a business that for one reason or another, it can be because it's the low cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has a moat around it."
- Warren Buffet at 1995 Berkshire Hathaway annual meeting of shareholders
The moats mentioned by Warren above are no different than competitive advantages that companies enjoy relative to their peers that enable market and profit pool capture. As we looked for frameworks to solidify our understanding of the types of competitive advantages, we chanced upon a framework developed by Pat Dorsey that categorize moats into different categories and therefore creates an effective mental model to understand how a select few companies manage to maintain very high returns on capital for long periods of time by developing structural advantages.
The concept of moats has been widely misunderstood, in this post we try to make some sense of the same and provide simple examples in the Indian and Global context to solidify the concept.
Put simply, a moat is a structural advantage that insulates a firm from competition.
Moat Type 1 - Intangible Assets
The first category pertains to intangible assets which simply explained are assets that are not physical in nature i.e those you can't see or physically touch.
Is John Cena an intangible asset? IDK.
Intangible assets may be formed as a result of research and development expense that leads to know how and expertise in specific niche industries or selling and marketing expense that leads to a creation of widely recognized brand names. Books such as Capitalism without Capital and academic research into the topic have cemented what the more initiated investor has always known, the show is almost always behind the curtains in a run down theater tucked away from main street. The two intangible assets Dorsey lists in his framework are Brands and Patents, Licenses and Approvals.
A strong brand creates an economic moat around its profits and increases a customer’s willingness to pay by delivering benefits beyond the expected i.e. psychological benefits such as status or reduced mental fatigue in making a purchase decision. These benefits and how they accrue to both the customer and the company are discussed in further detail below:
Brands may create aspirational value for customers, this delivers pricing power to the company that owns the brand (think of how a Gucci bag that costs hundreds to make sells for lakhs). Pricing power implies the ability of a firm to raise prices while retaining sales volumes.
A successful brand elicits trust in the mind of the customer which in turn lowers the search cost for a customer and thereby leads to repeat purchase.
In a country like India where more often than not the customer ends up buying a good or service that is the lowest in terms of cost (examples being purchase decision in the airline or telecom industry), an established brand name enables a company to add factors beyond price to a customer's decision criteria. The money spent on establishing brands pays for the investment multiple times over if a company is able to extend the brand to other adjacent categories and increase the total addressable market without diluting the brand’s power. This is called brand extension at B Schools.
Tanishq and Tata group
An example of successful brand extension is the Tata brand name which is a household name that evokes feelings of trust and quality independent of the positioning of its children brands like Tanishq, Titan, Tetley, etc .
This parent brand was leveraged by Tanishq during initial years of operations in the 1990s to signal virtues such as honesty, transparency and quality that are ubiquitous with the Tata name and over time have also come to be associated with Tanishq.
All Tanishq store fronts mention that it is a Tata product, thereby capitalizing on the values of the parent company
When Tanishq commenced operations in the 1990s their market research pointed out that a major pain point for the Indian consumer while purchasing jewellery was being charged for higher caratage while being sold lower caratage products . In an effort to address this issue and build on virtues of trust and transparency, Tanishq management procured machinery for each store that verified the caratage of jewellery being sold to customers; this capital expenditure paid for itself several times over as it cemented the Tanishq brand as one customer’s could trust, a factor of paramount importance when high value purchases are made by the Indian consumer.
Nestle and Maggi
An industry where the power of brands is evident is FMCG; a lot of marketing rupees are spent by companies in the FMCG industry in initial years to establish a brand with a view to harvest exceptional profits in the long run.
Nestle’s Maggi which has become synonymous with the instant noodles category is a classic example of brand power. In 2015, the brand which was built over 35 years and is loved by students, housewives and everybody else was banned due to the Food Safety and Drug Administration (FSDA) spotting traces of MSG and lead in the noodles. From commanding ~80 percent market share, Maggi’s market share went straight to zero in give or take a month. Competitor’s like ITC and Patanjali sensed an opportunity and attempted to capitalize on the gap in satisfying the markets demand left by Maggi’s withdrawal.
However these efforts were for naught and once the matter with the FSDA has been settled Maggi was back at ~60 percent market share once the noodles were relaunched thereby settling any questions about the brand’s power and capability to bounce back from the setback once and for all.
Patents, Licenses and Approval
Patents, licenses and regulatory approvals are usually granted and are dependent on government regulations. Competitive advantages arising from such regulations tend to be sticky and once gained ensure that economic profits will continue to be harvested over the period of protection granted by such regulations. While everything described above might sound rosy and be at the surface appear to be the clearest source of wealth creation for shareholders, getting such protection from competition can be extra ordinarily hard. Let’s understand this once again in the context of one of our favorite companies, Nestle.
Nestle and Nan
The milk products and nutrition category contributes to approximately 50% of Nestle’s sales and largely consists of infant nutrition products which have inelastic demand. A little known fact that makes all the difference in the world to why this category is so lucrative for Nestle is that the Indian government’s regulations prohibit advertising any infant food for children between six months to two years of age. This law make it very difficult for a new player to enter the infant nutrition category and create a new brand , to the extent where the global leader, Johnson & Johnson could not get a license to sell in India. In a category where the Government effectively curbs any fresh competition via regulation, Nestle is the well-established market leader in infant cereals (97% market share) and infant formula (67% market share). These industry regulations pertaining to curbs on advertising lead to a) the legacy dominance in terms of market share of Nestle staying established b) significant pricing power and c) lower advertising spends thereby leading to higher margins; a powerful combination that results in extremely high returns for the Company.
Moat Type 2 – Switching Costs
Switching costs in simple terms refer to the one time hassles which customers face to move from one service/product to another. These costs can be explicit (in terms of monetary expenses to make a switch) or implicit (in terms of mental strain or pure lethargy associated with making a switch from status quo). Therefore, while making a decision to switch from one product/service to another a customer that faces high switching costs might elect not to make any changes unless he foresees a significant reduction in price or significant improvement in utility from the alternative.
Let us take two contrasting examples to drive home the point further – a) the sexy, fascinating ultimate consumer tech company Apple and b) the boring Indian banking sector.
Apple and the ecosystem
When one thinks Apple one tends to think iPhone. The iPhone contributed 54 percent of Apple’s revenues in 2019. However, a question that deserves pondering is what results in a customer while making a purchase decision select a new variant of the iPhone over other alternatives. Is it the company’s innovations that make a superior product? Perhaps in initial years when the iPhone and touch screen mobiles where a novelty however today with innovation in mobile phones stagnating and competitors ripping off anything new that Apple does (think the design improvement to the iPhone X by increasing the screen size which is available on every Android phone today), probably not. Is it the fact that iPhones sell at a higher price point which coupled with Apple’s branding results in demand for iPhone as an aspirational product? Maybe, but there are enough high end Android phones in the market that provide superior hardware at cheaper price points.
We believe the real reason the customer selected Apple every time is that Apple combines software, hardware and services to deliver an ecosystem unlike any of its competitors thereby enabling the company to command a premium in a commoditised market. Apple hooks in customers by offering what is arguably a superior user experience. As an individual buys in and starts using more Apple products and services (like Apple Watch, AirPods, iCloud, Apple TV+ and Apple Pay), they get more firmly entrenched within this ecosystem.
The foresight to focus on creating an ecosystem in the past is why Apple makes the big bucks today.
Think at an individual level about how many iPhone users you know that made a switch to Android. (Maybe a few). On the other hand think about how many Android users you know that aspire to owning an iPhone at some point. Apple’s competitors will have to manufacture multiple products at lower price points and with higher or equivalent utility to make an enticing enough proposition that can at some point perhaps displace Apple’s dominance.
Indian Banking Sector
Let’s assume you’ve been living under a rock in 2019. Chances are you’d have still heard that some form of trouble was brewing at Yes Bank. As a rational individual/corporate who has money with the bank the first thing you’d do is probably withdraw all your cash from a bank that is at the risk of going under, right? Despite all the negative news and constant media coverage, the bank still had Rs 2 lakh crore worth of deposits during the crisis. This example simply shows how current account and savings account (CASA) deposits are a massive moat for a bank. The reason for existence of this moat is also pretty obvious - changing banks involves filling out forms and also changing paying arrangements for recurring payments which is a hassle. Sounds extremely simplified but in a business where services are fairly commoditised and every bank will provide the same service suite this hassle can be a significant hindrance in the mind of a customer while making a switch.
Banks are well aware of the lethargy associated with switching bank accounts in a customer’s mind and therefore give low interest rates and charge high fees for switching accounts. Additionally, the low turnover of depositors encourages banks to target building up a significant CASA franchise given this gives the bank a stable capital base upon which lending and wealth management operations can be built. Therefore, it is not surprising that high CASA franchises like HDFC Bank, City Union Bank and Kotak Bank - all with CASA ratios above 40% have been immense wealth creators and newer competitors like IDFC First have been aggressively trying to garner retail deposits.
Moat Type 3 – Network Effects
Network effects are the buzz word every tech founder will claim as their moat. Network effects are representative of a state which result in additional users being acquired at low or nil costs with the value of the service to users increasing with growth in user base.
Social Media and the power of Network Effects
The above definition for network effects might be non intuitive but a simple example cements the concept – let’s consider any social media network, say Facebook.
I joined Facebook back in the day because my friends were on Facebook, most parents in turn joined Facebook because their kids were on Facebook and so on the cycle rolled leading to Facebook gaining 200 million monthly active users and becoming the global hegemon that it is today. Basically the following things happened in sequence:
The number of people on Facebook increased
My interest in the platform and the amount of time I spend on the site increases due to more people on the network (more people = more content = more enjoyment = more time on site)
The more time I spend on the network the more data points I create for Zuck, creating data that can be monetised via advertising.
So, as Facebook grew in size, so did the user’s engagement with the network and so did the benefits reaped by the company.
This is exactly what good network effects look like: as the network grows in size all sides to the business also derive better value from the network. In the context of Facebook - the users get a better experience, the advertisers get to target exactly their customer segment due to better analytics and the company itself reaps profits having found a brand new marketing channel to monetize.
Graphical representation of how networks evolve over time and eventually can reach a colossal size.
As is evident from the above example, networks increase in value after reaching a certain tipping point (also called a critical mass). Like if only 2 of my 10 friends used Facebook I’d probably not be excited about joining the website. However, once say 6 of my 10 friends have joined Facebook I am going to join the website as well since the utility I get from the website is directly proportional to the number of people I know who are on it. Companies know this, they know that to get the ball rolling and to get people to sign up to the service they’ll have to entice them by either providing a superior offering or spending money on marketing (AKA customer acquisition costs) to build the initial mass of users. The next batch of users that will be attracted to the service will be because the initial cohort have already been acquired, therefore reducing marketing spend per marginal user in the long run. However, initial outflow of cash to build a stable base of users is increasingly common in such businesses.
Network Effects playing out in other Indian companies
Other industries that see similar examples where companies spend on building the initial mass of users are classifieds and marketplace models where these companies usually keep one side of the demand/supply chain free for the end user and charge the side on the opposite end of the transaction a premium/subscription fee for providing the service (think discounts funded by e-commerce websites to entice consumers).
In the Indian context many vertical online businesses have attempted to build network effects and a few have succeeded by targeting categories that are not crowded and do not involve competing with tech behemoths like Google and Facebook. Infoedge is a brilliant example where the flagship company naukri.com has over time built a repository of the highest number of resumes in India thereby forcing recruiters to pay for their offering to gain access to the largest pool of talent in the country. This has led to naukri having 80% of industry revenues along with 110% of industry profits, building a virtual monopoly in the job search market.
Another vertical player targeting a niche successfully is Indiamart. Indiamart is a domestic B2B e-commerce platform which has 6 crore users. The platform attracted around 8.8 crore buyers last year thereby making it extremely compelling for sellers to list their products on the website and thereby further fuelling network effects as buyers flock to the platform with the largest selection.
Exchanges have traditionally showcased network effects as well. In the Indian context we see this playing out with exchanges that have cornered either untapped areas or targeted larger addressable markets - leaders like Indian Energy Exchange, National Stock Exchange and MCX dominate in their respective niches. This dominance leads to more participants which leads to more liquidity which improves price discovery thereby improving the quality of the moat with each passing day.
Moat Type 4 – Cost Advantages
Cost advantages are exactly what they sound like: they are cost advantages (lol, we crack ourselves up). No seriously, cost advantages are some form of benefit that accrue to companies which enable them to lower expenditures and thereby increase their profitability margins.
Process based advantages
Process based advantages are structural advantages that accrue to businesses that have over time figured out ways to optimize operations, cut costs or increase the top-line. For example, every business school graduate has heard of Japanese techniques like Kaizen which has yielded an edge in manufacturing processes to Toyota which has in turn improved efficiency on the factory floor. Typically in commoditised, low differentiation industries process based advantages can be the sole differentiator between a company that makes abysmal margins and one that makes terrific margins.
Southwest Airlines in USA and Interglobe Aviation in India are low cost airlines that have optimized their operations to ensure low turnaround times for their flights and selection of routes that run at capacity.
Cement Industry - Another commodity industry
In the cement industry, another commodity business, Shree Cements, has consistently brought in the highest earnings before interest, tax, depreciation and amortization per tonne by focusing on supplying to areas in vicinity of production, a simple operational tweak that results in better returns to shareholders.
Fashion and Retail
Zara’s fast fashion strategy which is based on refreshing the stores selection frequently has also been successfully implemented by Westside and Zudio.
The stock market darling Avenue Supermart has also developed process based advantages. Avenue Supermart has aced the hub and spoke model of calibrated expansion and is able to get favourable terms from marquee FMCG names due to its bulk purchases and quick inventory turnover.
DMart's bulk purchase direct from FMCG companies translate to lower prices for customers and therefore a constantly crowded store, a beautiful site for any shareholder.
Scale based advantage
Scale based advantages accrue to companies that are large in size and therefore have better economics due to the fixed cost being distributed over a larger base. Due to the upfront expenditures that are incurred to build scale based advantages these moats are hard to replicate. Scale based moats can accrue to companies as a result of monetary expenditures on tangible or intangible assets that fundamentally shift the manner in which these businesses function – an example that comes to mind are distribution networks that are built over time as companies scale. Once built, they are very robust in nature.
Asian Paints and others
Several building material companies like Asian Paints, Pidilite and Astral Pipes would fall in this category. Asian Paints specifically made the early decision of cutting out the middle men and going direct to the customer’s purchase point thereby improving margins for the company.
Over the years, the number of such points of sale that are a part of the Asian Paints distribution network has steadily increased. Additionally, data about sales at each of these storefronts has also increased the data at Asian Paints' disposal that enables efficient management and even pre-emption of demand thereby increasing margins for the company.
Moat Type 5 – Good Management
Before we begin discussing the benefits of good management, a small disclaimer from the Oracle of Omaha that classifies quality of management on a lower pedestal as opposed to the aforementioned moats that are more intrinsic to a business, the moats discussed above tend to directly manifest in the business model and thereby directly impact margins.
“When a management with reputation for brilliance tackles a business with reputation for bad economics, it is reputation of business that remains intact.”
- Warren Buffet.
In short, the companies intrinsic competitive advantages matter more than the management, which is an exogenous variable.
That being said, the value that exceptional management can add in scaling a businesses with good economics cannot be understated. What’s more, all other moats mentioned above are usually created over the long run due to sustained and disciplined effort by competent management to create a competitive advantage. Therein lies the catch: moats aren’t likely to exist in a business where the management isn’t competent; however, the existence of a moat doesn't necessarily signal competent management.
In the Indian stock universe we note that the quality of management is where the majority of investable companies falter. The original promoter family which more often than not are majority shareholders in a company tend to be more concerned with lining their own pockets than creating long term wealth for minority shareholders.
However, there are a few companies that are blessed with good management which resist temptation and run the business in an efficient manner.
Asian Paints and management control
Asian Paints is an example of a wealth creator run by honest, competent management. It's no surprise that the stock has delivered an astonishing 21.6 percent returns per annum over the past decade.
In its initial 25 years, Asian Paints was a company largely run by the promoter - Champaklal Choksey, a shrewd businessman who understood the industry and worked continuously to identify and plug gaps in consumer demand. As Asian Paints grew in size, Choksey was proactive in building management depth by recruiting from the best business schools in the country. These early hires have gone on to hold key positions at the firm thereby aiding succession planning. Additionally, the company's recruits played a pivotal role in developing new capabilities such as data analytics; a term that is ubiquitous today but was a non-existent capability for most companies in the 1970s.
That's about it. We believe analyzing moats or sustainable competitive advantages of companies should be a key component of every analyst's analysis. Often a moat might not be immediately visible and might require a deep dive into the business, this can involve conversations with management, conducting channel checks, poring though decades of management commentary etc. All of this, while tedious, is necessary effort to pick winners for the long run.
The key to a successful investment thesis lies in identification of a moat, gauging the strength of the moat and the company's ability to monetize the same effectively.
See you next time! Do subscribe to our blog via the link below if you found this post interesting.
Please note that the above article is for informational purposes only and none of the companies mentioned above can be considered as investment advice.